Never discount Wall Street’s ability to turn the most basic parts of life into profits. Mother nature is the latest money spinner for financial firms. Despite the recent Northeast snowstorm, the unseasonably warm winter, and in general a lack of snow, could turn into big profits for the banks, brokerages and insurance firms that deal in so-called weather derivatives.
Financial contracts based on the weather have been around since at least the late 1990s. The contracts, many of which trade like stocks, are typically pegged to such things as rainfall and temperatures. But in the past few years, contracts specifically tied to snowfall have started to take off in popularity. The contacts essentially act like insurance, allowing, say, retailers or ski mountains to insure against too much snow or too little. Wall Street sells the contracts, matching buyers and sellers and pocketing a small commission. Typically, it’s a good business, but this year it could be a real moneymaker.
In theory, there could be as many firms betting against snow as for it. But in reality the market is always lopsided. It turns out there are more firms that are hurt by large snowfalls than the opposite. And large ski mountains have yet to get into the market. Vail Resorts, for instance, a public company that owns its namesake mountain as well as a number of others, says it doesn’t use weather derivatives to mitigate losses when snow is light. Jeff Hodgson, who runs the Chicago Weather Brokerage and specializes in snow derivatives, says he has yet to work with a ski mountain. What’s more, last year’s record snowfall caused more companies than ever to seek protection this winter.
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The result: unable to find sellers, brokers who specialize in the market say financial firms ended up taking other side of the trade in order to complete their clients transactions, essentially betting that snowfall would be light this year. “I’m short snow,” says Bill Windle, who heads up weather trading at reinsurance firm RenRe.
Back in September when most of these contracts are signed, that looked like a risky position. Now it looks likely financial firms could cash in. By this time in the year, about 50% of the United States is typically covered in snow. But as of the beginning of the year, just 20% of the country had snow on the ground.
Just how much money the financial firms will rake in and who will profit is unclear. Last year, PriceWaterhouseCoopers estimated that the total weather derivatives market was $12 billion. Snow is only a small portion of that, perhaps a few hundred million. But it’s growing. The number of snow contracts traded at the CME rose 55% to 510 in 2011.
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Typically, the way the contracts work is that the buyer and seller will settle on a number of inches of snow in a particular time period in a central area of a city. If accumulation is greater than that, the seller of the insurance has to pay out. But if the snowfall is less than the specified amount the contract will expire worthless. Along the way the contract can rise and fall in price. Hodgson says it initially costs about $19,000 to get $100,000 of snow insurance in Chicago. But prices can vary city to city based on how hard it is to predict annual snowfall. What’s more, the later in the winter you buy the contracts the more expensive they become.
While many of the financial firms that specialize in weather derivatives are specialized insurance companies, some are household names. An industry group the Weather Risk Management Association has 46 members including Morgan Stanley and Merrill Lynch, which is owned by Bank of America. Windle’s firm RenRe is one of the bigger players in the market. Windle believes the demand for weather derivatives will continue to grow. In a Businessweek article in September, Windle said he was betting his kids college education on the business. Things are looking up for the Windle’s children’s educational prospects.